Business Economics

Chapter 8 Cost and Revenue analysis

Prof. Harshad Sambhus

• Explain the concept of cost and discuss various types of costs

• Describe the short-run and long-run costs of production

• Explain the concept of economies and diseconomies of scale

• Explain the concept of economies of scope

• Explain the concept of revenue

Cost function describes the relationship between output and cost.

Output

= ???
 Concept of Cost

• COST is the Expenditure, measured in monetary terms, incurred or to be

incurred in order to achieve a specific objective.

• Cost is an important factor in business analysis and decision making especially

pertaining to the following aspects:

 Identifying the weak points in production management

 Minimising the cost of production

 Finding the optimum level of production

 Estimating the cost of business operations

 Determining the price margins for selling the goods produced

 Different Types of Costs
Opportunity costs
Explicit costs
Implicit costs
Accounting costs
Economic Costs
Business Costs
Full costs
Fixed costs
Variable costs
Incremental costs
Real Costs
Social Costs
Replacement Costs
Direct and Indirect Costs
 Different Types of Costs
• Opportunity cost is also referred to as alternative cost. An organisation has
limited resources, such as land, labour, capital, etc., which can be put to
alternative uses having different returns. Organisations tend to utilise their
limited resources for the most productive alternative and forgo the income
expected from the second best use of these resources.

• Let us assume that an organisation has a capital resource of Rs 1,00,000 and two
alternatives to choose from. It can either purchase a printing machine or photo
copier, both having a productive life span of 12 years. The printing machine
would yield an income of Rs 30,000 per annum while the photo copier would yield
an income of Rs 20, 000 per annum. An organisation that aims to maximise its
profit would use the available amount to purchase the printing machine and
forgo the income expected from the photo copier. Therefore, the opportunity cost
in this case is the income forgone by the organisation, i.e., Rs 20, 000 per annum.
 Different Types of Costs

• Explicit costs- Payments that the employer makes to purchase or own the factors
of production. These costs comprise payments for raw materials, interest paid on
loans, rent paid for leased building or machinery and taxes paid to the
government. For example, if an organisation borrows a sum of Rs 70,00,000 at an
interest rate of 4% per year, the interest cost of Rs 2,80,000 per year would be an
explicit cost for the organisation.

• Implicit costs- Costs that cannot be reported as cash outlays in accounting books.
Opportunity costs are examples of implicit cost. Depreciation Rent on Own
Premises etc. (implicit kind of costs)
 Different Types of Costs

• Accounting costs –They are recorded in the books of accounts of a firm and
appear on the firm’s income statement. It include all explicit costs along with
certain implicit costs of an organisation. For example, depreciation expenses
(implicit cost) are included in the books of account as a firm’s accounting costs.

• Fixed costs refer to the costs borne by a firm that do not change with changes in
the output level. Even if the firm does not produce anything, its fixed costs would
still remain the same.
• Economic costs includes both the accounting costs plus the opportunity cost. For
example, if you take time off work to a training scheme. You may lose a weeks
pay of 3500, plus also have to pay the other form of direct cost of Rs2000. Thus
the total economic cost = Rs. 5500/-
 Different Types of Costs

• Direct costs are those expenses which are directly related with the production of
specific commodity and an organisation can directly connect these costs with the
production of specific commodity. Direct cost is generally considered as variable
cost because it changes with the changes in level of production. For example,
Ford Motor Company manufactures cars and trucks. A plant worker spends eight
hours building a car. The direct costs associated with the car are the wages paid
to the worker and the parts used to build the car.
 Different Types of Costs
• Indirect Costs- They are the expenses unrelated to producing a good or service.
An indirect cost cannot be easily traced to a product, department, activity or
project. For example, with Ford Motor Company , the direct costs associated with
each vehicle include tires and steel. However, the electricity used in Ancillary
Departments lant is considered an indirect cost because the electricity is used for
all the products made in the plant. No one product can be traced back to the
electric bill.

• Sunk costs are those costs that a company has committed to and are unavoidable
or unrecoverable costs. Sunk costs (past costs) are excluded from future business
decisions because the costs will be the same regardless of the outcome of a
decision. For example, once rent is paid, that dollar amount is no longer
recoverable - it is 'sunk.‘
 Different Types of Costs

• Business Costs- Business costs include all the expenditures incurred to carry out
a business. These costs are used to calculate the profit or loss made by a business,
filing for income tax returns and other legal procedures.

• Full Costs- Total cost of all resources used or consumed in production, including
direct, indirect, and investing costs.

• Fixed Costs- Fixed costs refer to the costs borne by a firm that do not change with
changes in the output level. Eg. Rent, EMI…. etc.

• Variable Costs -Variable costs refer to the costs that are directly dependent on the
output level of the firm (Eg. Extra Performance Incentives, MSEB Bill, Raw
Material Charges)
 Different Types of Costs
• Incremental costs – It involves the additional costs resulting due to a change in
the nature of level of business activity. It characterises the additional cost that
would have not been incurred if an additional unit was not produced. As these
costs may be avoided by avoiding the possible variation in the production, they
are also referred to as avoidable costs or escapable costs. For example, if a
production house has to run for additional two hours, the electricity consumed
during the extra hours is an additional cost to the production house. The
incremental cost comprises the variable costs.

• Real Costs- It refers to the actual expenses carried out by the various members of
the society in the process of production of goods and services. In simple words, it
is the total expenses of raw material, direct labour, advertising, transportation,
etc. which emerges in the process of producing goods or services for the
customers. Includes other intangible factors, in addition to cash, such as time,
labor, lost opportunity, etc.
 Different Types of Costs
• Social cost- It refers to the total of all private and external costs that an entire
society has to suffer in any economic activity. For example, suppose a new airport
is built in the your city then the cost of constructing, salary of workers,
maintenance expenses, etc. will be considered as the private costs while loss of
landscape, noise and air pollution, risks of accidents, etc. will be considered as
external costs. In this case, social cost will be calculated by adding both private
and external costs.

• Replacement cost- It is also known as replacement value. It is the cost which

refers to the total amount of expenses that an organisation suffers in replacing an
old asset with a similar kind of new asset. For example, suppose a company buys
a new machinery worth Rs 1 crore and on the same day it sells old machinery of
similar kind for Rs 25 lakh. Then in this case replacement cost of machinery will
be calculated by deducting sale proceeds from old machinery from price of new
machinery or replacement cost for machinery = 10000000 - 2500000 = Rs
7500000.
 Short Run Costs of Production

• A short-run period refers to a certain period of time where at least one input is
VARIABLE while others are FIXED. In the short-run period, an organisation
cannot change the fixed factors of production, such as capital, factory buildings,
plant and equipment, etc. However, the variable costs, such as raw material,
employee wages, etc., change with the level of output. If a firm intends to
increase its output in the short run, it would need to hire more workers and
purchase more raw materials. The firm cannot expand its plant size or increase
the plant capacity in the short run. Similarly, when demand falls, the firm
would reduce the work hours or output, but cannot downsize its plant.

• The Short-Run Total Cost (SRTC) of an organisation consists of two main

elements:

SRTC = TFC + TVC

 Short Run Costs of Production

Total Fixed Cost (TFC): These costs do not change with the change in output. T F C
remains constant even when the output is zero. T F C is represented by a straight line
horizontal to the x-axis (output).

Total Variable Cost (TVC): These costs are directly proportional to the output of a
firm. This implies that when the output increases, T VC also increases and when the
output decreases, T VC decreases as well.
 Short Run Costs of Production

Quantity Total Total Total Cost Average Marginal

(Q) Fixed Variable (SRTC = Cost Cost
Cost Cost TFC + TVC) (SRAC= (SRMC)
(TFC) (TVC) TC/Q)
20 10 15 25 1.25 -
21 10 20 30 1.43 5
22 10 10 20 0.91 -10
23 10 12 22 0.96 2
 Short Run Costs of Production

Short-run Average Cost

The short-run average cost (SRAC) of a firm refers to per unit cost of output at
different levels of production.
𝐒𝐒RTC TFC+TVC TFC TVC
SRAC = = = +
Q Q Q Q
𝑇𝐹𝐶 𝑇𝑉𝐶
=Average Fixed Cost (AFC) and =Average Variable Cost (AVC)
𝑸𝑸 𝑸𝑸

Therefore, SRAC = A FC + AVC

 Short Run Costs of Production

• S R A C of a firm is U-shaped. It declines in the

beginning, reaches to a minimum and starts
to rise. In the beginning, the fixed costs
remain the same while only the variable
costs, such as cost of raw material, labour, etc.
changes. Later, when the fixed costs get
distributed over the output, the average cost
begins to fall. When a firm utilises its
capacities to the full, the average cost reaches
to a minimum. It is at this point that the firm
operates at its optimum capacity.
 Short Run Costs of Production
• A typical average cost curve has a U-shape,
because fixed costs are all incurred before any
production takes place and marginal costs are
typically increasing, because of diminishing
marginal productivity. In this "typical" case, for
low levels of production marginal costs are below
average costs, so average costs are decreasing as
quantity increases. An increasing marginal cost
curve intersects a U-shaped average cost curve at
the latter’s minimum, after which the average
cost curve begins to slope upward. For further
increases in production beyond this minimum,
marginal cost is above average costs, so average
costs are increasing as quantity increases.
 Long Run Costs of Production

Long-run Total Cost

• Long-run total cost (LRTC) refers to the total cost incurred by an organisation for
the production of a given level of output when all factors of production are
variable.

• It is the per unit cost incurred by a firm when it expands the scale of its
operations not just by hiring more workers, but also by building a larger factory
or setting up a new plant.
• The shape of the long-run total cost

curve is S-shaped.
 Long Run Costs of Production

Long-run Total Cost

The shape of the long-run total cost curve is S-shaped. For relatively small quantities
of output, the slope begins to flatten. Then, for larger quantities the slope makes a
turn-around and becomes steeper. In the L RTC curve, the flattening portion is due to
the increasing returns to scale or economics of scale and similarly, the reason for
steepening portion is decreasing returns to scale or diseconomies of scale.
 Long Run Costs of Production

Long-run Average Cost

• Long-run average cost (LRAC) refers to per unit cost incurred by a firm in the
production of a desired level of output when all the inputs are variable.

• The L R A C of a firm can be obtained from its individual short-run average cost
curves. Each S R A C curve represents the firm's short-run cost of production when
different amounts of capital are used. The shape of the L R A C curve is similar to
the S R A C curve.
• The negative slope of the L R A C curve

depicts Economies of scale. On the other

hand, the positive slope of the L R A C curve

represents Dis-economies of scale

 Long Run Marginal Costs of Production
• If the firm’s production process is subject to increasing
returns to scale and the average cost of production falls as
output increases. Similarly, when there are decreasing
returns o scale the average cost of production must be
increasing with output.
• The L A C curve is U-shaped, just like the S A C curve but
the source of the U-shape is increasing and decreasing
returns to scale, rather than diminishing returns to a
factor of production.
• The long-run marginal cost curve shows for each unit of
output the added total cost incurred in the long run, that
is, the conceptual period when all factors of production are
variable. When long-run marginal cost is above long
run average cost, average cost is rising.
 Economies of Scale

Economies of Scale

• As a firm expands its production capacity, the efficiency of production also

increases. It is able to draw more output per unit of input, leading to low average
total costs.

Internal economies of scale:

• These refer to the economies that a firm achieves due to the growth of the firm
itself. When an organisation reduces costs and increases the production, internal
economies of scale are achieved. Internal economies of scale refer to the lower
per unit cost that a firm obtains by increasing its capacity.

External economies of scale:

• These refer to the economies in production that a firm achieves due to the growth
of the overall industry in which the firm operates.
 Diseconomies of Scale

• Diseconomies of scale refer to the disadvantages that arise due to the expansion
of a firm’s capacity leading to a rise in the average cost of production.

• Internal Diseconomies

i. Managerial inefficiency- When a firm expands its production capacity, control

and planning also need to be increased. This requires the administration to be
more efficient. Due to the challenge of managing a bigger firm, managerial
responsibilities are delegated to the lower level personnel. As these personnel
may lack the required experience to undertake the challenge, it may result in
low output at higher cost.

ii. Labour inefficiency- When a firm expands its production capacity, work areas
may become more crowded leaving little space for each worker to work
efficiently.
 Diseconomies of Scale

• External diseconomies: External diseconomies of scale refer to the disadvantages

that arise due to an increase in the number of firms in an industry leading to
over production.
 External Diseconomies of Scale Factors
The concentration of firms within an industry increases the demand for raw
•

materials. This leads to an increase in the prices of raw materials

consequently increasing the cost of production in the industry.

•heconcentration of firms within an industry increases the demand for

T
skilled labour. This leads to an increase in the wages of the skilled workers
consequently increasing the cost of production in the industry.

•heconcentration of firms within an industry may lead to problems of waste

T
disposal. Firms are bound to employ expensive waste disposal or recycling
methods, which increases the long run cost of production.

•he concentration of firms within an industry may lead to excessive need for
T
advertising and promotion, consequently increasing the cost of production in
the industry.
 Economies of Scope

• Economies of scope refer to the decrease in the average total cost of a firm due to
the production of a wider variety of goods or services.

• Economies of scope can be attained by sharing or joint utilisation of inputs

leading to reductions in unit costs.

• Economies of scope allow organisations to generate operational efficiencies in

production.

• Example - Proctor & Gamble, which is a multinational manufacturer of product

ranges, including personal care, household cleaning, laundry detergents,
prescription drugs and disposable nappies. Procter & Gamble can lower the
average total cost of production for each product by spreading the input costs
across its range of products.
 Economies of Scope

• There are several ways through which an organisation can attain economies of
scope. Some of these ways are as follows:

• Flexibility in manufacturing: If a manufacturer can produce multiple products

‰
using the same equipment and maintains flexibility in manufacturing as per the
market demand, the manufacturer can attain economies of scope.

• Sharing of resources: When a firm share the operational skills, manufacturing

know-how, plant facilities, equipment or other existing assets.

• Mergers and acquisitions: Mergers may be undertaken to enhance or expand a

manufacturer’s product portfolio, increase plant size and combine costs. For
example, several pharmaceutical organisations have consolidated their research
and development expenses for bringing new products to market.
 Concept of Revenue

• Revenue is the total amount of money received by an organisation in return of the

goods sold or services provided during a given time period.

• Revenue of a firm refers to the amount received by the firm from the sale of a
given quantity of a commodity in the market.

• The concept of revenue consists of three important types of revenues:

Types of
revenue

Total Average M arginal

revenue revenue revenue
 Concept of Revenue

Total Revenue
• Total Revenue (TR) of a firm refers to total receipts from the sale of a given
quantity of a commodity.

• Total revenue is calculated by multiplying the quantity of the commodity sold

with the price of the commodity. Symbolically,

Total Revenue = Quantity × Price

• If a firm sells 10 fans at a price of ₹ 2,000 per fan, then the total revenue would
be calculated as follows:

10 fans × ₹ 2,000 = ₹ 20, 000

Concept of Revenue
Concept of Revenue
 Example – Concept Building
• For example, Mr. A sells 50 packets of homemade chips every day and he incurs
some cost to sell and produce them. He determined the price of each packet to be
$5, adding all the cost and his profit, where his profit is $1.50 per packet.

• Now, Mr. A produced 55 packets one day by mistake and took all of them to the
market. With no surprise, he was able to sell all 55 packets for $5 each. He made
his usual $250 by selling 50 packets.

• In addition to that, he sold 5 packets, which were produced by mistake. He was

selling the packets for $5 and since he sold 5 additional packets, he had a
Marginal Revenue of $25 ($5 x 5).

• This is how Marginal Revenue is calculated. It is dependent on supply and

demand, and on the type of market as well, such as Perfect
Competition or Monopoly or Oligopoly
 Marginal Revenue

• If M R is greater than zero, the sale of an additional unit increases the TR.
‰

• f‰
I M R is below zero, then the sale of an additional unit decreases the TR.

• f‰
I M R is zero, then the sale of an additional unit results in no change in the TR.
• Marginal revenue (MR) can be less than average revenue (AR) because M R can
be positive, zero or negative. On the other hand, AR reflects price of a commodity
which always remains positive.
 TR, AR,MR

Price Quantity Total Revenue Average Marginal

(P * Q) Revenue Revenue
10 0 0 0 -
10 1 10 10 10
9 2 18 9 8
8 3 24 8 6
7 4 28 7 4
6 5 30 6 2
5 6 30 5 0
4 7 28 4 -2
 Let’s Sum Up

• Inputs produced multiplied by their respective prices, when added together

constitute the money value of these inputs referred to as the cost of production.

• Economies of scale result in cost saving for a firm as the same level of inputs
yields a higher level of output while diseconomies of scale refer to the
disadvantages that arise due to the expansion of a firm’s capacity leading to a
rise in the average cost of production.

• Economies of scope refer to the decrease in the average total cost of a firm due to
the production of a wider variety of goods or services.

• Revenue is the total amount of money received by an organisation in return of the

goods sold or services provided during a given time period.
 Quiz

1. Which of these costs include the return from the second best use of the firm’s
limited resources, which it forgoes in order to benefit from the best use of these
resources?
a. Fixed costs
b. Explicit costs
c. Implicit costs
d. Opportunity costs
2. Which of these arises due to an increase in the number of firms in an industry
leading to over production?
a. Internal economies of scale
b. External economies of scale
c. External diseconomies of scale
d. Internal diseconomies of scale
3. Economies of scope are usually attained by manufacturing large batches instead
of small batches of many items. (True/False)
 Quiz

1. Which of these costs include the return from the second best use of the firm’s
limited resources, which it forgoes in order to benefit from the best use of these
resources?
a. Fixed costs
b. Explicit costs
c. Implicit costs
d. Opportunity costs
2. Which of these arises due to an increase in the number of firms in an industry
leading to over production?
a. Internal economies of scale
b. External economies of scale
c. External diseconomies of scale
d. Internal diseconomies of scale
3. Economies of scope are usually attained by manufacturing large batches instead
of small batches of many items. (True/False)